Why Firms Cluster
There are many significant reasons why firms would choose to cluster together in a city. The economic forces which cause this clustering are called agglomeration economies. Localization economies are when firms locate within one single industry. Urbanization economies are when firms locate across industry boundaries. One firm may have an incentive to move closer to another firm eventually creating a dense city.
Sharing Intermediate Inputs
Firms may locate close to one another in an effort to share intermediate inputs. This is important with industries or firms that have similar inputs and can benefit from being close to one another. By sharing intermediate inputs they should be able to cut production costs and increase specialization thus making production subject to economies of scale. Many high-tech products are made up of smaller components which make it useful for firms to locate where these smaller components are being manufactured.
Sharing a Labor Pool
Firms are able to share workers when locating close together. This helps people to find what they are good at and for firms to hire productive people for their particular production item while a person may be better suited for working with a different firm. This also ties into the idea of labor matching. A firm can lose a lot of money training workers who do not have the necessary skills for their job, but in a big city, they have a larger area of workers to choose from and thus better matches between workers and employers can be produced.
This is helpful in causing firms to cluster as they can gain from one another's knowledge and hopefully educated workers. From examining these different concepts, it seems that firms can benefit greatly from locating in a cluster. They can share inputs and a labor pool, provide better skills matching among workers, and generate knowledge spillovers. All of these things contribute to lower production costs which in turn will increase profit for the firms.
Joint Labor Supply
Firms have an advantage to clustering when taking into account joint labor supply. This refers to married couples who often seek places to live based on what jobs are available. This means that different types of firms clustering together will attract those couples who have to consider each individual finding a job. Having different firms in one area is beneficial to both the workers and the firm. Often, those who are married and both parties are working tend to have a higher level of education thus adding to the labor pool from which the firms can choose. These firms clustering lead to the development of a larger urban area to which couples interested in joint labor supply will be attracted.